Yeah, sounds like you're not maximizing the green box. I normally touch the corner of the green box and expand it to its full size (though now I see that all I need to do is touch any edge and pull away from the center). Then I slide it left/right on my 3:2 aspect ratio photos to choose what I want to include in the wallpaper.
If you're getting anything blown up and pixelated, it's cause your green box was not expanded to its full size.
Here's a screenie of what the green box should look like when you are in the process of resizing it. I took this shot with my finger still on the green box while shaking the phone (to trigger the screenie). Apparently my finger slipped a little and the green box shrunk a bit. but basically you want to stretch it so that the green touches the edges of the image.
If anyone is curious, I took that photo in Mykonos, Greece.